Semiconductors have turned into a gigantic industry over the past few decades. Estimates have global spending at $553 billion in 2021, up from a measly $33 billion worldwide in 1987. Analysts expect the industry to continue growing to almost $1 trillion in total annual spending by 2030, as there is an increased demand for computing processes around the world with the growth of electronics, data centers, and artificial intelligence (AI) technology. On top of these secular tailwinds, the chip industry is being held back due to supply constraints around the world right now, which should push spending higher over the next few years.
Many investors focus on the companies that make or design chips, like Nvidia, Intel, or Taiwan Semiconductor Manufacturing (TSM). However, as with any gold rush, the smarter move might be to own the company providing the picks and shovels to the industry. Enter Applied Materials (AMAT 0.77%). Here's why the semiconductor equipment company is a monster opportunity in the global chip shortage.
What is Applied Materials?
Applied Materials is a semiconductor equipment company, which means it provides equipment, services, and software to semiconductor manufacturers like TSM and Intel. These include technologies that allow manufacturers to create, shape, modify, analyze, and connect computer chips, among other processes. The equipment is very complicated, but for our purposes, you just need to know that manufacturers go to Applied Materials to help improve their chip-building processes.
The company has a very defensible position in the marketplace with all these different technologies, with 15.7 thousand active patents at the end of last quarter. It also spends an enormous amount of money on research and development (R&D), adding up to $2.5 billion over the last 12 months. On top of this, it would be incredibly difficult for a start-up to come in and replace Applied Materials at large manufacturers like TSM and Intel because of the high switching costs and capital intensity these firms would need to go through.
Taking all these factors into consideration, it is pretty clear that Applied Materials has a long-term competitive advantage or moat, which should insulate it from most competitors as it tries to sell equipment to semiconductor manufacturers.
Strong track record of growth and profitability
Applied Materials has been able to ride the wave of semiconductor growth over the past few decades. In the first-quarter report for 2022, which ended in January, the company did $24.2 billion in trailing 12-month revenue, up from less than $10 billion 10 years ago. And remember, this is despite a current shortage of semiconductors worldwide. Management thinks demand for wafer fabrication equipment (WFE), its most important end market, will hit $100 billion in spending in 2022 compared to $80 billion in spending last year. While still a relatively long way out, management thinks that 2023 spending will be even higher than 2022. Given Applied Material's defensible position in the marketplace, its annual revenue should be able to grow along with the increase in industry demand.
Revenue growth is nice, but don't forget about what truly matters to investors: profits and cash flow. Applied Materials has a strong track record of generating both. Over the past 12 months, operating income and free cash flow (FCF) hit $7.7 billion and $6 billion, respectively. Both metrics have grown in tandem over the past decade as Applied Materials has scaled its business along with the overall semiconductor industry. As revenue grows over the next decade, operating income and FCF should rise as well.
Cheap valuation if you have a multi-year time horizon
With a defensible position in the industry plus strong prospects for future profit growth, there's only one thing left to consider for investors when it comes to Applied Materials: valuation. Luckily, right now, the market is valuing this high-quality business at a fairly cheap price. As of this writing, Applied Material's stock has a market cap of $118.4 billion. With $6 billion in trailing FCF, that gives the stock a price-to-free-cash-flow ratio (P/FCF) of 19.7, below the Nasdaq's average of 30. If Applied Materials can grow its business at a steady clip along with the semiconductor industry over the next decade, buying in at a P/FCF below 20 should do wonders for shareholders.
Don't forget the capital returns, either. Applied Materials has a dividend yield of 0.73% and has reduced its share count through share repurchases by 17% over the last five years. Add these on top of the underlying business growth, and investors should get strong total returns from holding Applied Materials over the long run.